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Transcript of Chapter 15
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Chapter 15
Conflicts of Interest in the Financial Industry
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.15-2
Conflicts of Interest
• Type of moral hazard problem that occurs when a person or institution has multiple objectives and as a result has conflicts between them
• Might be responsible for
– Previous scandals (Enron)
• Enron: The Smartest Guy in the Room
– Subprime financial crisis of 2007-2008
– Li Xuli (Rat Trading, Caijing.com.cn)
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Conflicts of interests
• a conflict of interest – as a situation in which a party to a transaction
can potentially gain by taking actions that adversely affect its counterparty. (Mehran and Stulz, 2002, Journal of Financial Economics, The Economics of Conflicts of Interest in Financial Institutions)
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Conflicts of interest
• conflicts of interest – used to describe the situation in which a public
official or fiduciary who, contrary to the obligation and absolute duty to act for the benefit of the public or a designated individual, exploits the relationship for personal benefit, typically pecuniary.(Encyclopedia of American Law)
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Conflicts of interest in financial industry
• Possible causes:
– Information and cost advantage of financial intermediaries
• Economies of scale realized from cost advantages in the collection and use of information
• Economies of scope realized by providing multiple financial services to customers
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Conflicts of interest in financial industry
• Undesired consequences– Possible adverse effect on customers
• might misuse information, provide false information, or conceal information.
– Less efficient financial markets• Misuse of information• Reduced quality of information• Outright fraudConflicts of interest increase financing cost
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Types of Conflicts of Interest
• Underwriting and research in investment banking
• Auditing and consulting in accounting firms
• Credit assessment and consulting in credit-rating agencies
• Universal banking
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Underwriting and Research in Investment Banking
• Issuers and investment banks benefit from optimistic research– Investors desire unbiased research
• Investment banks have strong incentive to alter information, favoring the issuing firm– Morgan Stanley internal memo
– Blood on the Street, by Gasparino, 2005• The booming 1990s, research analysts, traders, kickbacks
• Spinning
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Morgan Stanley internal memo
an internal Morgan Stanley memo excerpted in the Wall Street Journal on July 14, 1992, stated: “Our objective ... is to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice.”
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Frank Quattrone
• Nearly 200 IPOs in 1990s• $120m annual pay• Upenn, Stanford• Morgan Stanley, Deutsche Bank,
Credit Suisse First Boston• 2003, legal charges
– See FINRA new release
• 2008, founded Qatalyst Group– 70% premium for clients vs.
typical 37% (Reuters article, 2011 Sep 14)
• Smith Interview About Frank Quattrone (Bloomberg video)
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Auditing and Consulting in Accounting Firms
• Auditing:– Primary functions (validate information)
– Other consulting services (taxes, business strategies)
• Pressure from clients threatening to take business to another firm
• Reluctant to criticize work done by nonaudit counterparts
• Provide an overly favorable audit in an effort to solicit or retain audit business
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The case of Arthur Anderson
• Anderson’s Auditing and Consulting businesses, and their bitter dispute
• Enron’s accounting practices– Offshore entities– Mark-to-market– Enron as a large regional customer
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Credit Assessment and Consulting in Credit-Rating Agencies
• Credit rating – default probability• Conflicts of interest
– Issuer-pay business model
– Investors and regulators depend on well-researched impartial assessments
– Credit-rating agencies may also provide consulting services
• Auditing their own work• Favorable rating to attract new clients
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Credit rating agencies and the subprime crisis
• Three major credit rating agencies:– Moddy’s, S&P, Fitch
• Issuer pays• 90-95% revenue from rating services• Rating derivatives more profitable than rating corporate
bonds (3 times)
• Massive downgrade during the crisis– S&P – 16,381 out of 31,935 tranches– Consequences: capital loss, forced sale of assets,
further devaluation
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Testimony by former executive at Moody’s
[A] large part of the blame can be placed on the inherent conflicts of interest found in the issuer-pay business model and on rating shopping by issuers of structured securities. A drive to maintain or expand market share made the rating agencies willing participants in this shopping spree...Originators of structured securities typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality.
- Testimony to Congress, U.S. House of Representatives, Committee on Oversight and Government Reform, Hearing: Credit Rating Agencies and the Financial Crisis, 10/23/2008
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Universal Banking
• Underwriting department: aggressive sales vs. unbiased investment advice for customers.
• Limit losses by selling to customers or to trust accounts
• Encourage underwriting to push securities from firms with increasing risk
• Makes loans with overly favorable terms to earn fees for other activities
• Influence or coerce a borrowing or investing customer to buy insurance products
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Inside Job
• 2010 Academy Award for Best Documentary Feature
• 2006-2008 financial crisis– Iceland crisis– Subprime crisis in U.S– Regulation vs. deregulation– Banking system– Rating agencies– Even in academics (82:00)
• http://v.youku.com/v_show/id_XMzA0MTY1MTg0.html
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Can the Market Limit Exploitation of Conflicts of Interest?
• Conflicts of interest – adverse selection, moral hazard
• Factors may limit exploitation – Not very high incentives – Reputation consideration– Long run profitability
• Empirical evidence suggests that – Credit rating firms do not overrate bonds of its customers. – markets adjust when a potential for conflicts of interest arise
(securities underwriting by commercial and investment banks).
– See Mehran and Stulz, 2007, JFE paper
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Can the Market Limit Exploitation of Conflicts of Interest? (cont’ d)
• In the short run, exploitation is possible and can lead to large gains. Motives:– Poorly designed compensation plans.
– Temporary rewards
• Individuals might be able to capture reputational rents.
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Sarbanes-Oxley Act of 2002
• Also known as “Public Company Accounting Reform and Investor Protection Act”
• Primary objectives:– Increased supervisory oversight to monitor and
prevent conflicts of interest• establishes the Public Company Accounting Oversight
Board
– Directly reduced conflicts of interest• restricts auditing companies from providing non-audit
services (e.g., consulting) for the same clients
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Sarbanes-Oxley Act of 2002
• Primary objectives (continued):– Provided incentives for investment banks to not
exploit conflicts of interest• specific criminal penalties for manipulation, destruction
or alteration of financial records or other interference with investigations
– Had measures to improve the quality of information in financial markets
• enhanced reporting requirements for financial transactions
• establishes standards for external auditor independence
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Global Legal Settlement of 2002
• An enforcement agreement between the SEC, NASD, NYSE, and ten of the United States's largest investment firms to address issues of conflict of interest within their businesses
• Primary actions– sever the links between research and securities
underwriting– Banned spinning– $1.4 billion of fines on accused investment banks.– make public their analyst’ s recommendations– to contract for a five year period with no fewer than three
independent research firms that would provide research to their brokerage customers
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Framework for Evaluating Policies
• a conflict of interest serious adverse consequences (necessarily)– Does the market have adequate information and
incentives to control conflicts of interest?
• Eliminating the economies of scope may reduce the flow of reliable information
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Approaches to Remedying Conflicts of Interest
• Leave it to the market– Penalize the financial service firm– Promote new institutional means
• Regulate for transparency– Mandatory information disclosure– Might be too costly for financial service firms
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Approaches to Remedying Conflicts of Interest(cont’ d)
• Supervisory oversight– Overseeing appropriate internal controls
• Separation of functions– Agents should not be placed in the position to
respond to multiple principals
• Socialization of information production– Information is likely to be undersupplied if left to
private provision.